Why A Hedge Fund Comprised Of Junior Congressional Democrats Should Outperform The Market By 9%

That insider trading in Washignton occurs with a greater frequency than at Galleon is no secret. Courtesy of various loopholes, members of both the House and Senate have long been allowed to trade on inside information, something that grabbed the media's attention when back in November 2005 someone, somewhere sent the stock of USG Corp., W.R. Grace & Co., and Crown Holdings higher even though there was no public information. Only later would it become known that then-Senate Majority Leader Bill Frist would deliver a speech announcing new legislation to relieve companies of asbestos litigation. Subsequent studies (such as Ziobrowski et al's 2004 paper “Abnormal Returns from the Common Stock Investments of the United States Senate.”) confirmed substantial market outperformance by members of Senate. A few days ago, Ziobrowski et al, have released a follow up study "Abnormal Returns From the Common Stock Investments of Members of the U.S. House of Representatives" which confirms that not only do congressional critters consistently outperform the market, but does a granular analysis of just who it is in congress that should consider leaving the public arena, and raising capital to start their own hedge fund: simply said, junior, democratic congressmen beat the market by roughly the same amount, with the same consistency (and probably with the same Sharpe ratio) that allows SAC to charge 3% and 35%.

In a nutshell, the latest stereotype is that if one is a junior democrat in Congress, and one trades for their own discretionary account, one most likely is doing so using insider information.

From the authors:

We find that stocks purchased by Members of the U.S. House of Representatives earn statistically significant positive abnormal returns. The returns outperform the market by 55 basis points per month (over 6% annually). As additional evidence of information advantage, the trade-weighted portfolio of purchased stocks significantly outperforms the equal-weighted portfolio indicating that Representatives invested much larger amounts in those stocks that performed best. The regression coefficients also suggest that House Members favor the common stocks of smaller growth companies with slightly above-average risk.

Who is a better daytrader: republican or democrat?

When stock purchases are equal-weighted we find no significant abnormal returns for either Democrats or Republicans. When the  portfolios are tradeweighted, the samples of both Democrats and Republicans produce positive, statistically significant CAPM alphas. Only the Democratic, trade-weighted portfolio yields a significant positive Fama-French alpha. Furthermore, the nested test for significance of party affiliation indicates that the Democratic sample significantly outperformed the Republican sample. The Democratic sample beat the market by 73 basis points per month (nearly 9% annually) versus only 18 basis points per month (approximately 2% annually) for the Republican sample.

One explanation for this bias:

Given the almost folkloric belief that Wall Street invariably favors Republicans, the superior performance of trades made by Democratic Representatives may seem surprising. However, it should be noted that Democrats controlled the House for 10 of the 17 years covered by this study. Furthermore, Democrats were deeply entrenched in the leadership of the House for decades prior to the study. Thus when Republicans finally took control in 1995, they arguably had far less experience at handling the reins of power and may therefore have been unable to immediately enjoy all its perquisites.

Additionally, greedy junior politicians are more adept at "beating" the market than more senior ones.

In addition, stocks purchased by Democratic Representatives significantly outperform stocks purchased by Republican  Representatives. Stocks purchased by Representatives with the least seniority significantly outperformed stocks purchased by Representatives with the most seniority.

The explanation: risk versus return:

Again we find this result counterintuitive. In theory, Representatives with the most seniority possess the most power and thus should have the greatest opportunity to trade with an informational advantage. However, although the most senior Members may have the most opportunity, they may lack the strongest motive. It is no secret that money is the lifeblood of politics. Whereas Representatives with the longest seniority (in this case more than 16 years), have no trouble raising funds for campaigns, junkets and whatever other causes they may deem desirable owed to the power they wield, the financial condition of a freshman Congressman is far more precarious. His or her position is by no means secure, financially or otherwise. House members with the least seniority may have fewer opportunities to trade on privileged information, but they may be the most highly motivated to do so when the opportunities arise.

The conclusion.

In sum, the findings from this study of the U.S. House of Representatives’ common stock transactions are generally supportive of the previous study of the U.S. Senate. We find strong evidence that Members of the House have some type of nonpublic information which they use for personal gain. That having been said, abnormal returns earned by Members of the House are substantially smaller  than those earned by Senators during approximately the same time period. These smaller returns are due presumably to less influence and power held by the individual Members. The nature and source or sources of information is unknown, but clearly further research is warranted. We recommend that congressional committees should be studied for abnormal returns and indications that members of those committees may favor stocks in industries their committees oversee. Abnormal returns associated with the common stocks of specific industries or companies should be investigated for patterns of potential misconduct. We suggest the examination of the relationships between campaign contributions, common stock acquisitions, and abnormal returns.

In other words, everyone is trading on inside information, but nobody more so than those who write the laws that determine just what is considered Insider information, and the penalties associated with it. In the meantime, let the public lynching spectacles of such prominently irrelevant fund managers as Raj Raj continue: the people need their bread and circuses. Especially as fund of funds round up all junior democrats and start roadshowing them to yield-hungry QIPs.

Full report:

Abnormal Returns